Securities Finance Times feature article

DLT-based innovation is reshaping securities finance architecture and attracting new providers and consumers of collateral into the market. Bob Currie examines the development pipeline

Fifteen years after publication of the seminal paper by Santoshi Nakamoto, Bitcoin: a Peer-to-peer Electronic Cash System, distributed ledger technology (DLT) continues gradually to penetrate the world of securities finance, finding selective application across a range of use cases as firms upgrade their approaches to transaction record keeping and seek efficient ways to lend and finance their inventories of traditional and digital assets.

This study, by the researcher or research group calling themselves Nakamoto, laid the early foundations for use of blockchain-based record keeping in financial services. Now the DLT world is maturing, attracting new entrants, driving partnerships and takeovers, and generating competitive pressures that have already forced some DLT fintechs to exit the market. Product specialists are working with their technology teams to identify new use cases where DLT may offer benefits — while those that have launched commercial services on blockchain are looking for ways to scale these applications. Fifteen years is still a relatively short timeframe in the advance of a technology, but it gives us clues about how the project pipeline may develop.

Paul Pirie, J.P. Morgan executive director and collateral management product manager, tells Securities Finance Times (SFT) that, for J.P. Morgan, the benefits offered by DLT as a technology are “undeniable”. His firm’s primary focus in the near term is to apply DLT to improve collateral velocity and mobility, particularly in its agency lending and collateral management functions.

In a recent conference panel on DLT and its application in securities finance hosted by SFT, it was striking that each participating firm has a live DLT-based application that is currently up and running and delivering real benefits to customers. In this sense, this was not simply a forward-looking discussion speculating on what is possible in the future. Rather, participants have completed the design, testing and release of a prototype solution, a minimum viable product, and they are delivering live solutions to their clients.

“Within J.P. Morgan, we have a well-established suite of private permissioned blockchain solutions through the Onyx business unit,” says Pirie. “This provides an operating system on which business lines can develop their own applications — enabling J.P. Morgan to be fast to market with digital products and solutions.”

One example is the development of J.P. Morgan’s intraday repo product, launched in 2020, where J.P. Morgan’s Collateral and Trading teams have worked with the Onyx business unit to develop an intraday repo product which involves the exchange of tokenised collateral against tokenised cash in the form of J.P. Morgan Coin. “Blockchain allows us to exchange these tokens simultaneously, eliminating intraday credit exposure for the transaction,” says Pirie. “Consequently, this provides a very compelling use case.”

In May 2022, J.P. Morgan also announced that it has settled its first transaction using tokenised money market funds (MMFs) as collateral. This uses a tokenised collateral network in steps to increase the velocity of collateral. Following this successful execution of a collateralised trade using tokenised MMF shares, J.P. Morgan plans to expand this model to enable transfers of tokenised equities, fixed income securities and other assets as collateral.

Richard Glen, solutions architect at HQLAX, indicates that the Luxembourg-based fintech has focused on the pain points inherent in collateral settlement and the drag that this has traditionally placed on bank capital or liquidity. Conventional market practice has been to settle collateral transformation transactions using two free of payment (FoP) securities transfers or two delivery-versus-payment (DvP) settlements. The former consumes bank capital in instances where FoP deliveries are not simultaneous, thereby consuming intraday credit. In contrast, DvP settlements consume intraday liquidity against the respective cash payment legs.

The fact that settlement occurs at unspecified and often imprecise times within settlement windows forces banks to maintain buffers of collateral and liquidity to manage these exposures — and this translates into operating costs, regulatory cost, as well as opportunity costs, for the firms concerned. This is compounded by an increasing demand for collateral — driven partly by regulatory initiatives such as Uncleared Margin Rules (UMR) — and by an appetite for higher collateral velocity.

According to Glen, DLT can play an important role in meeting these requirements. We live in a world where users expect prompt delivery in many walks of life — and this extends to mobilisation and delivery of collateral. Not only does DLT enable transfer of securities to be executed immediately; it also allows for transfer of ownership to be finalised at a precise moment in time. This creates new opportunities to support intraday markets in both the DvD and the DvP space — and reduces operational risk and associated costs for banks and their clients.

Matthew Wolfe, executive director and product owner for Renaissance Clearing at OCC, indicates that when the Chicago-based clearing house asked its members to identify their greatest pain points, it received a clear message that daily reconciliation challenges with their counterparties were foremost in their priorities.

In 2020, OCC announced plans to develop and implement a DLT solution to replace its existing securities lending infrastructure. It selected Axoni, a technology firm that specialises in multi-party workflows and infrastructure, as its technology partner in developing this service.

According to Wolfe, OCC’s new DLT-based stock loan system has provided additional benefits: an opportunity for OCC to expand in the DLT space and to provide a relatively low-cost way to improve risk management and operational efficiency for its clearing members.

In practice, clients typically operate trading systems, billing systems, custody systems and a range of other systems. Using traditional database technology, it can be challenging to ensure that these records are fully aligned. However, using DLT technology firms can run each of these in-house systems from a common synchronised record. The user may take a node on the blockchain record, utilising a data streaming service to synchronise across each of their internal systems.

In short, a primary benefit of implementing DLT is for both the lender and borrower to have a direct connection into a ledger and be able to view their positions in real time. Wolfe explains that users can clear transactions through OCC, or trade bilaterally with counterparties, confident that they are working off the same version of the contract as other parties to the trade, rather than relying on a daily update, typically through exchanging end-of-day batch files. The state of a contract is visible in real-time throughout the day. This can also improve audit procedures and transparency. Agent lender disclosures and regulatory compliance obligations such as Reg SHO can be managed more efficiently and at lower cost via DLT.

According to Michele Hillery, managing director for DTCC equities clearing and settlement products, DLT has the potential to lessen or eliminate many of the reconciliation overheads that it encounters currently — ensuring that users are working from a common, shared book of record held on blockchain. Among other benefits, this will allow DTCC to simplify the data architecture that it currently maintains, removing the requirement for extract, transform, load (ETL) layers within its current ecosystem, for example, that are used to consolidate data from multiple data sources into a single consistent record. “Overall, we consider this to be a major opportunity to deliver greater operational efficiency to our clients,” says Hillery.

In reviewing this process in more detail, Hillery notes that securities finance transactions are just one element of a much wider securities processing flow that DTCC manages on a daily basis.

DTCC is being selective in where it will apply DLT applications across its service portfolio based on where it can deliver the best value and efficiencies. For US cash securities markets transactions, for example, peak clearing volumes typically average between 200 and 250 million transactions daily and DLT-based systems are not yet well suited to processing this level of transaction volume.

That said, Project Ion — DTCC’s DLT-based alternative settlement platform that is due to go into production in mid-2022 — is exploring settlement, and is limited to bilateral transactions. “I envision that as DLT matures, and the industry has wider take-up of this emerging technology, we could see DLT used for a broader set of transactions, as well as potentially in other parts of the post-trade lifecycle,” says Hillery.

Significantly, as a clearing entity, OCC’s Wolfe also indicates that the application of DLT is enabling OCC to manage credit risk more accurately and at an earlier point in the trade lifecycle. Traditionally, in the case of OCC’s Stock Loan/Hedge programme, when the lender and borrower have negotiated the loan, the details are sent to the depository. Following the delivery-versus-payment confirmation, OCC records and guarantees a loan between the lender and the borrower. However, the delivery confirmation of the current system does not include the terms of the loan (e.g. the dividend rate, the rebate rate, any term structure, etc.) and this limits what OCC can guarantee, causing the lender and borrower to have some residual bilateral credit exposure. The lack of information is also a barrier to expanding clearing services such as supporting non-cash collateralised loans.

Wolfe explains that under the new programme based on DLT, OCC will have the full contract details, allowing it to expand its guarantee of Hedge Program transactions. An example of this improvement is that OCC will be able to maintain rebate rates and calculate accrued interest. The accrued rebate amounts will be settled on a netted basis with OCC, replacing the current process of creating payment orders for every counterparty.

Managing transition

When considering implementation, DTCC’s Michele Hillery indicates that a key challenge lies in managing a transition to a DLT-based environment for a diverse range of DTCC users. This ranges from large Tier 1 investment banks with sophisticated technology and a relatively sizeable annual technology budget through to small and mid-tier broker-dealers that have a smaller level of resource they can dedicate to technology upgrades.

By this point, some larger firms are likely to take a node on the blockchain, while others will access the DLT transaction record through their existing messaging systems, through API, through a web-based user interface or through other channels. “At DTCC, we must be able to accommodate this full spectrum of users, ensuring that we continue to provide reliable clearing and settlement services to the full marketplace,” says Hillery.

DTCC plans to share more information on the delivery mechanisms as it goes live with Project Ion, proving the effective functioning of the minimum viable product to the market and demonstrating the resiliency, security and scalability required to support the future of its clearing and settlement services.

HQLAX’s Richard Glen indicates that by utilising digital transfers of ownership — which eliminates the need to move underlying assets between custody accounts — the DLT solution offered by HQLAX enables users to manage collateral transformation trades for assets held in different silos. This allows users to hold these assets for safekeeping in their preferred location, whether this is driven by existing custodial relationships and asset servicing requirements, the need to optimise scale and cost efficiencies, or their ability to access liquidity using triparty.

“The HQLAX solution builds on this decision model, allowing users to manage and transfer the ownership of collateral assets held in different silos without settlement friction,” explains Glen. This is particularly advantageous for portfolio managers looking to generate additional yield on hard-to-fund assets, for example, as well as clients that need to source collateral to cover initial margin (IM) or variation margin (VM) obligations with clearing houses or UMR counterparties.

Alongside the above, other DLT-based initiatives are also gaining traction in the securities finance arena. In June 2021, Broadridge Financial Solutions announced the release of its distributed ledger repo (DLR) platform. This allows users to agree, execute and settle repo transactions on the platform, enabling transfer of ownership using smart contract while immobilising the underlying securities, dictating that these underlying securities do not need to be moved between custody accounts (as discussed above).

SFT has also reported on plans to release an interbank repo and FX swaps platform, which is currently in testing and scheduled for release in mid-2023 (see SFT Issue 305). In June 2022, 14 large banking groups completed a trial to execute intraday repo and FX swaps through an interbank platform built by Finteum and a number of these banks have indicated that they plan to go live on the service when this is launched. The firm established a relationship at an early stage with DLT specialist R3 and is building on the R3 Corda blockchain.

Speaking to SFT, Finteum co-founder Brian Nolan indicates that this will be one of the first interbank venues to support intraday FX swaps and intraday repos alongside each other in the same platform, enabling treasury teams to use these two markets interchangeably to manage their financing requirements. The platform aims to use existing settlement infrastructure, with the trial assuming DvP settlement using Euroclear Bank’s triparty infrastructure. BNY Mellon’s triparty infrastructure can also be used to settle US dollar intraday repo transactions executed on the Finteum platform. Finteum is also trialling settlement with digital settlement rails such as the Fnality Payment System and the company indicates that it is open to extending these DvP options according to demand from participating firms.

Promoting interoperability between solutions

Steve Sullivan, managing director and head of strategic solutions at SETL, notes that a wide array of tokenised assets are being created that can potentially be used in secured financing transactions. However, in many cases, firms are trying to manage these assets within their existing trading and post-trade infrastructure, rather than using this as an opportunity to adopt a new strategy and architecture.

“Perhaps this is the time to explore a new approach,” says Sullivan. “Firms may explore opportunities created by digital assets as a new line of revenue, a new P&L. The key is to look afresh and evaluate how we would really like securities finance to be done. This may allow us to strip out all the operational costs and inefficiency that persist from use of traditional models and legacy architecture — costs that remain because firms find it difficult to depart from the way this business has traditionally been conducted.”

At SETL, the focus is on providing an interoperable layer between different DLT entities, enabling tokens to move efficiently regardless of whether a ledger is supported on Ethereum, Hyperledger or another blockchain system. SETL will talk to a wide range of protocols, whether permissioned or public blockchain, providing the layer that links together the internal organs of these systems and, in turn, linking this environment to external parties. “As firms extend their ability to work across tokenised and traditional assets, it makes sense to have one single place to do your business, accessible through a single user interface,” says Sullivan.

In developing DLT-based solutions, J.P. Morgan’s Pirie indicates that collaboration is particularly important. The danger of fragmentation is very real and J.P. Morgan has worked closely with clients, peers, fintech companies and other partners to promote interoperability across the market. “In doing so, we aim to promote choice and flexibility, recognising that there should not be one, but multiple solutions, available to the user,” he says. With this in mind, J.P. Morgan has developed in-house solutions working with Onyx Digital Assets, but it is also a strategic investor in HQLAX.

In creating the J.P. Morgan intraday repo product, the incentive was to tackle the significant levels of intraday funding that were historically supported on an unsecured basis and to bring this into a secured financing transaction, thereby delivering capital savings to both the cash provider and the receiver.

“The technology is now in place to support this solution and we know it works, having released minimum viable products and developed these into solutions that are now in production,” says Pirie. “Technically, we can deliver these solutions very quickly.”

But he warns we should not underestimate the legal and regulatory complexity surrounding use of DLT-based solutions. For users, it is clearly essential that the collateral receiver has certainty over their claim to the posted collateral. “Our ability to provide answers to these fundamental legal questions has been critical to the success of the solution,” says Pirie.

DTCC’s Michele Hillery argues similarly that in transitioning to a DLT-based centralised ledger, DTCC’s Project Ion team is clear that it must do so without creating new sources of fragmentation — ensuring that the new DLT-based systems that it introduces must be able to communicate and interoperate efficiently with each other.

Does this require DLT?

In this article, industry experts have outlined a range of compelling benefits that application of distributed ledger technology can bring to the securities finance arena. A question that has been underexplored by industry commentators, however, is how far DLT is really necessary to achieve these objectives. Arguably, many of these goals come back to good data discipline. With this in mind, SFT asked whether these outcomes could be delivered equally effectively on a relational database or other ‘traditional’ database architecture (eg SQL, NoSQL)?

HQLAX’s Glen indicates that there are certainly some data management benefits offered on blockchain that can be managed in a traditional database. But DLT offers advantages in minimising or eliminating the reconciliation overhead, and in providing greater information security and resilience. Beyond this, there are some real cost savings that come from using DLT technology.

“For HQLAX, a primary objective is to make collateral settlement failures a thing of the past — and DLT technology is important in supporting this objective,” says Glen. By working from a single shared book of record held on blockchain, key decision makers in the front office will be able to access all of the salient information that they need in one place — integrated into their trading apps — and without the need to log into multiple legacy interfaces or to make multiple calls or email exchanges across middle and back-office.

As we move through the next few years, Glen indicates that the key to project delivery will be the improvement of the linkages between the analogue and the digital world and the ability to integrate traditional assets and digitally-represented assets within a single collateral inventory. “With this in mind, we are working closely with business specialists and technology teams to evaluate the different integration options available and to help the business sponsors realise the benefits of implementing a digital collateral environment,” he says.

SETL’s Sullivan embraces a similar commitment to driving integration across tokenised and traditional assets. In December 2021, SETL announced that it would work with SWIFT on an innovation programme pilot designed to promote interoperability in the advance of a tokenised asset market. Through a series of experiments, the company has been working with SWIFT, Clearstream, Northern Trust and other participants to evaluate token issuance, redemption and DvP settlement in efforts to create a frictionless market for tokenised assets. This will work with established payment mechanisms and with central bank digital currencies.

SWIFT notes that one of the key risks that the market must confront in an environment where tokenised and traditional assets coexist is that this will generate a fragmented patchwork of technologies, platforms and regulatory regimes. To prevent this fragmentation, Sullivan indicates that SETL is working to promote integration between DLT environments, offering its PORTL toolset to allow organisations to build applications that interoperate across a wide range of enterprise DLT protocols, including Corda, DAML, Besu and Fabric, and SETL’s own proprietary ledger.

For HQLAX’s Glen, the technology is an enabler in itself. In a digital age where data is king and cyber resilience is at the top of every chief technology officer’s (CTO’s) agenda, many banks have looked at the costs of maintaining a patchwork of legacy systems and are assessing solutions to provide them with transparency, security and simplification at a more scalable level. DLT provides the opportunity to drive content efficiently into vendor-style “applications” that provide real-time visibility over collateral positions. In doing so, these provide a single golden source of truth which streamlines reconciliation challenges. Importantly, these also provide an optimised data source to drive post-trade analytics.

Inevitably, how this operates in practice will depend on how a firm’s workflow is structured. But with the DvD collateral transformation solution that HQLAX offers, a firm can see in its front-end systems when transfer of ownership for a securities basket has been finalised. Glen indicates this is a major advance over previous arrangements, when typically it would require a call to the settlements team, or at least the need to access other middle and back-office databases, to confirm the status of a collateral transfer or collateral transformation trade.

A wide range of digital assets can be exchanged using DLT and, for the agency lending and collateral management team at J.P. Morgan, the focus has been on supporting transfers of tokenised securities and tokenised cash — both applying tokens that reference an underlying asset.

“When we refer to tokenisation, we are deliberately avoiding creating a new transferable security,” says Pirie. “Rather, we are creating a digital representation of ownership of the underlying asset.” The focus is on creating liquidity through tokenisation by creating a secondary market in tokenised assets. In doing so, it is possible to create liquidity in a fixed asset, an underlying asset that may itself be relatively illiquid. In future, tokenised securities referencing the underlying asset may also potentially be used as collateral, providing these meet the collateral eligibility criteria specified by the collateral receiver.

Based on these considerations, J.P. Morgan believes that tokenisation will be an important tool in enabling clients to manage hybrid portfolios and to generate increased liquidity and mobility in their traditional assets. “In future, institutional clients may invest in natively-issued digital fixed income assets alongside their traditional asset holdings, for example, and it is important that we can manage this confluence of the traditional and digital world and help clients to make efficient use of this hybrid collateral inventory,” says Pirie.

While OCC recognises that while the power of DLT is tremendous, Matt Wolfe notes that DLT is also not a monolithic single solution to every challenge. OCC is building its DLT solution to be interoperable across vendor and in-house solutions and on tech stacks both old and new. “We are also working closely with a number of ecosystem partners to ensure we stay on this path to interoperability and deliver an enhanced system for the industry,” says Wolfe.

Paul Pirie believes that J.P. Morgan has established a strong foundation through the DLT products that are now live. “On consulting with clients, as we develop our roadmap for the next 12 to 18 months, we are confident that this client demand will translate into growth of volumes through these services,” he says.

Over time, J.P. Morgan is confident this will generate scale in the tokenised collateral space and will potentially change the way that the industry handles securities financing. This is likely to be accompanied by the entry of new collateral providers and consumers of collateral — firms that are not active in securities finance currently but are likely to become active participants in this space in months and years ahead.

Structured Settlements